Latvia’s Recovery Continues As It Eyes Euro Adoption

A year after completing a difficult adjustment program, Latvia is the fastest growing economy in the European Union.

Despite the recession in the euro area, Latvia’s GDP growth is projected to have exceeded 5 percent for the second year in a row in 2012. The labor market is improving, but unemployment remains too high.

As proof of its strong recovery, Latvia repaid last December the outstanding amount of its IMF loan. Under the original schedule, the final repayment would have taken place in 2015.

In an interview marking the conclusion of Latvia’s post-program monitoring discussions with the IMF, mission chief Shekhar Aiyar discusses with IMF Survey the country’s performance over the past year, its goal of adopting the euro in 2014, the challenges it continues to face, and what it will take to bring down unemployment.

IMF Survey online: What is the outlook for Latvia’s economy? Are the problems in the euro area having an impact on growth prospects?

Aiyar: Latvia is doing remarkably well. It grew at about 5 percent in 2011; and although the final numbers are not in yet, we expect that growth will again exceed 5 percent in 2012. Our outlook for 2013 is for continued recovery, but at a somewhat slower pace.

More importantly, unemployment continues to fall rapidly, underpinned by strong job creation. The unemployment rate fell from over 16 percent in the first half of 2012 to 13½ percent in the third quarter. Inflation is low at 1.7 percent and is expected to decline further. All this suggests that problems in the euro area have not derailed Latvia’s progress.

Nonetheless, there are certainly risks emanating from the euro area. If financial market stresses were to resurface, for example, Latvia’s borrowing costs might increase. And a prolonged period of weak growth in the euro area would take its toll on Latvia’s prospects.

IMF Survey online: What factors have allowed Latvia’s exports to thrive when the euro area—Latvia’s main trading partner—hasn’t been performing well?

Aiyar: One thing to remember is that Latvia doesn’t depend completely on the euro area for its exports. Some of its major export partners are outside the euro area: Russia, Sweden, and Lithuania. Latvia has also been successful in seeking out non-traditional export markets.

Last year also saw an extraordinary harvest, which helped agricultural exports. All these factors have been propping up exports despite the weakness in the euro area.

IMF Survey online: In addition to exports, what have been the main drivers of growth in Latvia?

Aiyar: Growth has been well balanced between domestic demand and external demand. Robust domestic demand has been driven by both consumption and investment.

Higher employment has meant more disposable income for families and greater demand by households. Profit margins for firms have also been good, raising the demand for investment.

Aiyar: Unemployment is the country’s chief challenge, and we believe that at this point the major component of unemployment is structural. Structural unemployment has many causes, and it increased during the crisis. Many people lost their jobs during the recession and were unable to quickly find another—a phenomenon that causes skill erosion and tends to perpetuate long-term unemployment. Then there are mismatches between jobs and skills, and, in common with other countries in the region, a large informal economy.

Lowering structural unemployment, which we estimate at about 12 percent, will require deep-rooted reforms to improve the business environment, enhance competitiveness, and attract more foreign direct investment. Some of these reforms are difficult and will take time to filter through the system.

Priority areas include reforms to the judicial system to address court system delays and curb abuses of the insolvency process; strengthen the governance and structure of state-owned enterprises; and improve the quality of higher and vocational education. The government is planning reforms on each of these fronts: the challenge will be to maintain the reform momentum under more benign conditions.

More could also be done to improve work incentives. For example, the Guaranteed Minimum Income (GMI) benefit—a form of social assistance for the poorest—is currently phased out one-to-one with any income that a recipient might earn. Phasing out this benefit more gradually would increase the incentive to find employment. An in-work tax credit is another idea worth trying.

IMF Survey online: What are the IMF’s concerns about changes to the Guaranteed Minimum Income (GMI) program?

Aiyar: The authorities have recently scaled back the GMI benefit from 40 lats per month to 35 lats per month. And responsibility for funding the program has been devolved fully from the center to local governments.

We are concerned about these developments, especially in the context of Latvia’s already high levels of inequality. Since the GMI is extended only to those without alternative sources of income, scaling down the assistance would hit the most vulnerable the hardest. It is possible that some cash-strapped local governments will be unable to provide even the reduced benefit, which would tend to exacerbate both poverty and inequality. Local governments—being closer to the ground—are better suited to delivering the benefit and monitoring eligibility, but we believe that the program should be centrally funded.

We are optimistic that the authorities will reconsider changes to the GMI when the World Bank releases its forthcoming study on Latvian unemployment and benefit programs.

IMF Survey online: Latvia is considering adopting the euro next year. Is the country on track to meet the Maastricht criteria?

Aiyar: In terms of the fiscal deficit and public debt, Latvia should be comfortably within the Maastricht criteria thresholds. There are some technical uncertainties related to the inflation and the interest rate targets.

Inflation in Latvia is low and on a downward trend. Interest rates are also low at about 3 ½ percent. The European institutions will compare Latvia’s inflation and interest rates with those of a reference group of three European countries. There is some uncertainty about which countries would comprise that reference group. But the European Commission has assured the government that Latvia will be given fair treatment when assessing the inflation and the interest rate criteria.

The European institutions will also consider whether the country is meeting the convergence criteria in a sustainable way—a forward-looking assessment. Here, Latvia would do best by maintaining the momentum on structural reforms. We believe that Latvia’s adjustment during the program already demonstrates a strong track record.

IMF Survey online: With all the problems in the euro area, does the IMF still think that euro adoption is the right strategy?

Aiyar: On economic grounds we believe that Latvia is better off—and less vulnerable—inside the euro area, given its choice of a fixed exchange rate.

Latvians tend to be paid and shop in lats, but they tend to save, borrow, and take out mortgages in euros. Joining the euro area would make the financial system less vulnerable to shocks.

We support the government’s goal of euro adoption—it has always been the exit strategy of the program—but we would emphasize that the euro will not make other policy challenges miraculously disappear. Latvia will need to continue making improvements to its competitiveness by implementing the reforms I mentioned earlier.

IMF Survey online: This is Latvia’s last post-program monitoring discussion with the IMF. How will the IMF continue to engage with the country?

Aiyar: The Fund will remain very engaged with Latvia as a consulting partner, and we stand ready to provide technical assistance as and when needed, just as we do with all of the IMF’s 188 member countries.

Every 12 months we will have a full-fledged policy consultation—the so-called Article IV—where we meet with the government, social partners, and NGOs. The aim is to take stock of macroeconomic developments, canvass a variety of views on issues of importance to Latvia, and propose strategies to meet those challenges. The consultation is summarized in a report that is discussed by the IMF’s Executive Board.

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